Court Decision Affects Real Estate Purchase Price And Depreciation

Recent Tax Court Decision Rebuffs Allocation of Purchase Price to Depreciable and Non-depreciable Real Estate by Taxpayer

In a recent Tax Court decision, Nielsen v. Commissioner, T.C. Summ. Op. 2017-31 (May 8, 2017), the court found that the taxpayer’s allocation of the purchase price of rental real estate between land and buildings was unreasonable. Instead, the court agreed with the IRS that the local county assessor’s allocation was more reliable and persuasive.

Internal Revenue Code (IRC) §167 generally allows a depreciation deduction based upon the purchase price of qualifying property used in a trade or business. Further, IRC §168 prescribes the amount of the depreciation allowed per tax year. If a taxpayer acquires both depreciable and non-depreciable property, such as land, for a lump sum the taxpayer must allocate the total purchase price based upon the properties’ relative fair market values.

The taxpayers in this case purchased rental real estate at three locations in the Los Angeles area and each location included land (non-depreciable) and buildings (depreciable). The taxpayers claimed a depreciation deduction based upon the total purchase price of the properties (including the land) using the straight-line method of depreciation over a 27.5-year recovery period. In response, the IRS disallowed the portion of the claimed depreciation deduction it attributed to the land. The IRS relied upon the property tax valuations assessed by Los Angeles County in determining the cost bases of the non-depreciable land.

The taxpayers acknowledged that they incorrectly included the cost of the land in their computation of the depreciation deduction. However, they also contended that the county did not accurately assess the relative values of the land and buildings. Instead, they argued that the IRS should have relied upon either of two alternative valuation methods: (1) the land sales method or the (2) insurance method. The land sales method bases the land value on comparable sales of raw land and allocates the residual value to the buildings. The insurance method values the buildings at their replacement values as determined by various insurance companies and allocates the residual value to the land. The court viewed both the land sales and insurance methods as less accurate than the property tax assessment values used by the IRS.

This court case highlights the immense importance of basing the allocation of the total purchase price between depreciable and non-depreciable property in an authoritative enough way to satisfy the IRS. If not, the IRS can select its own valuation and allocation method that in all likelihood will be unfavorable to the taxpayer’s interest. Ideally a taxpayer should employ a qualified independent appraiser to calculate the allocation. Accordingly, this documentation should be as contemporaneous as possible to the purchase date. The taxpayer presents an even stronger case if the sales contract explicitly allocates the purchase price between the categories of properties as the courts typically assume a buyer and seller have adverse interests in allocating the price between depreciable property and the land potentially taxable at lower capital gains rates.

For ways of ensuring that your allocation of the purchase price of depreciable and non-depreciable property is acceptable to the IRS and other ways this Tax Court decision may affect your business situation please contact a tax professional.

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas.
https://www.linkedin.com/in/drquintana